In a world of low interest rates, savings accounts are not respected. They give you liquidity and security of principal, of course. But growth? No chance. And unfortunately for the hoarders, this is precisely the environment we have lived in for over a decade.
The return on money parked in the bank hovered around zero. It’s a depressing reality for risk-averse savers who don’t want to venture into assets like stocks and bonds to generate a return on their money. But the clear and present danger of inflation is changing the landscape. Interest rates are rising, which should mean savings account yields will finally get a boost.
And while the increase may be slow and less generous than you’d hope, even a push to 2% or 3% will be a refreshing change of pace for those who only experience higher yields in the history books. .
Why are interest rates rising?
Interest rates rise because of inflation. Inflation is rising due to many factors, including supply chain bottlenecks, intense consumer and cash-rich business demand, and monetary and fiscal policy that has proven to be a bit too generous for too long after the global pandemic. Mix it all up and you have the classic inflation culprit: too many dollars for too few goods.
To understand the link between interest rates and inflation, you must first understand the role of the Federal Reserve, which is the US central bank. The institution has the dual mandate of promoting price stability and full employment. Unfortunately, these two objectives are often incompatible. That is, they are at opposite ends of a seesaw. The Fed’s attention thus becomes an issue that is of most concern. For more than a decade after the Great Financial Crisis of 2008, the central bank’s priority has been to help the economy get us back to full employment (often defined as an unemployment rate of 4% or less).
But priorities change, inflation rises again and full employment is effectively achieved. The central bank has embarked on a new campaign to crush inflation and make price stability great again. Although it has many tools, interest rates are the ones that get the most attention. Here’s how it works.
When the economy is struggling and unemployment rises, the Federal Reserve lowers interest rates to reduce the cost of capital and stimulate economic growth. Low rates encourage consumers and businesses to borrow and spend.
When the economy is booming and prices are rising too quickly, the Federal Reserve raises interest rates to raise the cost of capital and take advantage of drags on economic growth. High rates discourage borrowing.
So far this year, the monetary wizards at the Fed have raised short-term interest rates from zero to over 2%, and Wall Street expects the increases to continue. According to this handy tool from FedWatch, the market expects a rise to 3% by the end of the year.
Will savings account returns increase?
Yes, savings account returns will increase with interest rates. And here’s why.
Although savings account returns do not directly track interest rates set by the Fed, they are correlated. Think about the business model of a bank. They borrow money from depositors to make mortgages, car loans, business loans, etc. The amount of interest they are willing to pay on deposits depends in part on the amount of interest they can collect on loans. If they charge 4% on a mortgage while paying 1% on the deposits used to fund the loan, they make a profit on the spread. If mortgage rates rise (and they do when the Fed starts raising interest rates), the bank can afford to offer more interest on savings accounts while maintaining its profit margin.
Here’s a second reason why your savings account yield should start to rise. Interest on Treasury bills (T-bills) increases as the Fed raises its rates. Banks don’t just use deposits to fund loans; they also invest them in liquid and risk-free investments such as treasury bills. A year ago, three-month Treasury bills were yielding 0%. Now they are paying 2.42%. If rates rise to 3% by the end of 2022 as expected, three-month Treasury bills should follow.
Competing banks that are doing their best to pass these rate hikes on to their customers are expected to offer a savings account yield that resembles the three-month Treasury yield. If yours doesn’t, then you are living under your privileges.
2 tips for getting higher interest rates on your savings
Now that we’ve explained what higher interest rates mean for your savings, here are two tips for boosting your return.
First, shop. Google “high yield savings accounts” to see what the top banks pay. At the time of this writing, Marcus by Goldman Sachs (NYSE:GS) offered 1.5%.
Second, create an account with Treasury Direct to buy government treasury bills. You can easily link your bank account and buy treasury bills in small increments. Think of it as a way to eliminate the middle man.
As of the date of publication, Tyler Craig had (neither directly nor indirectly) any position in the securities mentioned in this article. The opinions expressed in this article are those of the author, subject to InvestorPlace.com Publication guidelines.